Arnold Kling  

John Taylor vs. Ryan Avent

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Taylor writes,


The Fed has effectively replaced large segments of the market with itself--it bought 77% of new federal debt in 2011. By doing so, it creates great uncertainty about the impact of its actions on inflation, the dollar and the economy. The very existence of quantitative easing as a policy tool creates uncertainty and volatility, as traders speculate on whether and when the Fed is going to intervene again. It's bad for the U.S. stock market, which is supposed to reflect the earnings of corporations.

One of my favorite scenes from "the Bernank" was when it described how the Treasury, rather than selling bonds directly to the Fed, first sold them to "the Goldman Sachs" which then sold them to the Fed. It does seem like an unnecessary step, particularly now.

Avent writes,


There is no overstating Japan's economic disaster. Its real income per capita rose to 90% of America's in the early 1990s, but has since fallen back to 70% of the current American level. This failure has inspired many idiosyncratic explanations: demography, a zombie banking system, a corrupt political class, and so on. But idiosyncratic explanations look much less compelling now, with the rich world's large economies following on Japan's heels.

Pointer from Mark Thoma. Read the whole thing. Actually, I had to check twice to make sure that the piece was not written by Scott Sumner. The Sumner-Avent view is that we should try monetary expansion. John Taylor's view is that we should not.

I think that a necessary condition for taking Taylor's side is a belief that much of the unemployment these days is structural. I take that view.

I was not persuaded by Avent's argument concerning Japan. I do not find it implausible that Japan suffered structural problems that in some ways presaged ours. Japan had a property bubble; we then had a property bubble; Japan probably felt keenly the factor-price equalization effects of China's rise before we did. Overall, in my view, the duration of Japan's malady is hard to reconcile with a purely macroeconomic diagnosis.

On the other hand, a sufficient condition for taking Taylor's position is a view that, other things equal, more monetary expansion will lead to more inflation. I do not take that view, because I believe that inflation in the United States ultimately is going to be driven by fiscal policy. Taking the fiscal path as given, we might be better off monetizing sooner rather than later. Especially if Sumner-Avent turns out to be correct on the macro side.

It would be much better if the Fed were buying less debt. But the inflationary threat, in my view, is the amount of debt being issued. What worries me is not the debt that the Fed buys today, but the debt that the Fed will be forced to buy in the future, even if inflation picks up. Eventually, the government is going to find a way to default, and high inflation is one way to do it.

One side note is that some folks argue that the low interest rate on government debt is a sign that the government should issue more of it. This argument might be more persuasive to me if the Fed were buying a much smaller share. But the fact that the Fed is buying most of it says that (a) the markets do not necessarily agree with the low interest rate and (b) that as taxpayers we are not really benefiting from the low interest rate, since we are buying back (via the Fed) most of what we are issuing.


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COMMENTS (9 to date)
Joe Cushing writes:

The purpose of the monetary expansion is to support government spending. If we cut government spending, there would be no need for the expansion. I don't believe the spending is helping. I think it is hurting. I have history on my side.

Gabriel Weil writes:

I don't think anyone seriously disputes that, "other things equal, more monetary expansion will lead to more inflation". This is not, however a sufficient condition for siding with Taylor over Sumner/Avent/Yglesias. A major aspect of their argument is that the Fed should be willing to tolerate inflation above two percent as part of a mix with more real growth in order to get back to full employment. Even if there is significant slack in the economy, bottlenecks in certain sectors will lead monetary expansion to result in some additional inflation, along with really growth from utilization of currently idle resources.

mark writes:

I "read the whole thing" as you suggested. I found it very overgeneralized and thus rather trite. For example, I don't know what one does with statements like this: "The key fact of the Depression was not deflation; it was plunging demand; deflation was the symptom. A central bank commitment to fight deflation therefore leaves some monetary fruit unplucked. The recent crisis was much less severe than the Depression because central banks thought deflation prevention was critical; in fighting deflation they couldn’t help but prevent a big demand collapse." The first sentence is given as a fact but is in fact merely arguable and probably unverifiable. The third sentence makes it pretty obvious that the thesis/antithesis posited in that first sentence is really an overlap, not the opposition it was presented as two sentences earlier. This is fine if you're writing literature but this purports to be some kind of high quality social science. So the three sentences taken as a whole are bumping into each other pretty clumsily and it just feels like a "this is what we believe" kind of exposition, which is very unpersuasive.

Costard writes:
I was not persuaded by Avent's argument concerning Japan. I do not find it implausible that Japan suffered structural problems that in some ways presaged ours....

That Japan underwent a structural shift can be seen in their consumption/GDP. Whatever the nature of the event it was not simply monetary, or if it was it violates any idea of the neutrality of money. Japan's "health" in the 80's - and any illness afterwards - were concentrated in industry.

The graph also illustrates the difference between Japan 20 years ago and us today. Their debt growth financed production; ours financed consumption. The banks may follow a similar trajectory but the economic impact will be reversed. My guess is that consumption in this country has reached a generational peak; however any rebalancing in the U.S. will be dependent upon rebalancing in China and the other net exporters, who have done everything in their power - including, in the last 3 years, wrecking their financial systems - to increase consumption abroad by lowering it at home. Which raises the question: is it really monetary and fiscal policy that have been floating AD? Or is it a fall in P made possible by a rapid leveraging by our trading partners?

And unfortunately, China is unwinding. Loosening monetary policy means even more bad loans and more fragile banks, but unless they pull stronger growth - and higher asset prices - out of their hat, lending will dry up, an export industry dependent upon loans at negative real rates will go under, and we'll be looking at a supply shock in consumer goods. In which case the other side of 2% becomes likely, and not in a light-the-fireworks sort of way.

Clearly this is not the only drama playing out in 2012, but I see it as the most important one. The fact that financial markets are watching Europe, economists are building sandcastles and interest rates are heavily discounting inflation into the distant future, makes me think it more likely. In any event the only material question is whether China can go another round or not.

blink writes:

I am not sure whether to love this post or hate it. On one hand, it presents arguments I had not considered and leads me to re-think my own position. On the other hand, it scares me to think that you are right. Well, if we are really flying into a mountainside, I prefer the lens the sees through the fog.

Shayne Cook writes:

@ Arnold Kling:

The "unnecessary step" you refer to in your first comment is a requirement of the law. The Fed is precluded by its founding legislation from buying U.S. debt directly from the Treasury. The Fed can buy/sell Treasury debt as it sees fit to fulfill its dual mandate, but it must do it with 'private parties', not directly with Treasury. That artifact was included in the original legislation as a measure to preclude the Fed from degenerating into a "piggy bank" for political agendas.

Having said that, I would agree that the Fed has recently (and to a limited degree), indirectly become something of a "piggy bank" for political agenda anyway. And I think it was a mistake for them to do so. The good news is, they seem loath to exacerbate and continue that mistake, much to Sumner's (and most politician's) dismay.

On Japan ...
Japan is an island - with a relatively tiny population. Following the guidance of Adam Smith (the "Land, Labor, Capital" thing), Japan has taken that tiny land mass and tiny population and turned it into the world's third (previously second) largest economy. It did so by importing nearly all its raw materials, applying extreme efficiencies in its use of labor and transfers (value added), and then exporting to external markets - most notably, Europe and the U.S. With its primary export markets currently crippled with structural problems, its little wonder that Japan's GDP numbers are less than robust.

Not to mention the impact of its main export-economy competitor, China. It is no coincidence that Japan's "margins" deteriorated exactly in concert with the rise of it's competitor, China - both "shooting" (exporting) at the exact same markets. The emergence of competitors always degrades margins.

In short, Sumner and Avent have got it all wrong. More money from the Fed won't help the U.S. economy. And the Fed knows that. And even to the degree it could help, Japan and China are more than willing to supply it - at near zero interest rates - out of their current and prior export earnings. It's in their interest to do so to fund U.S. and European consumption of their exports.

As a reminder to all the Fed critics, the U.S. Federal Reserve is managing THE global reserve and transaction currency. U.S. currency supports and is critical to ALL global economies and most critical to the three largest economies, not just the U.S. And it's apparent the Fed realizes that, and isn't buckling under the pressure and criticisms of politicians and politician wanna-be types.

David C writes:

I would be willing to believe that much of today's unemployment is structural, but only if I saw evidence that there were sectors that had unfilled openings that were sizable relative to the unemployed population.

I can see that we may have too many carpenters, given the sorry state of housing construction. Which professions do we have too few of? I can't find any when I look at the data.

Shayne Cook writes:

@ David C:

Dr. Henderson has a post (just prior to this one) on part of a book by Edward Conard - "Unintended Consequences". I highly recommend that book - it will explain to you why today's U.S. (and Europe's) unemployment problems are structural.

Charles R. Williams writes:

Just what is the significance of the fed swapping excess reserves paying 25 basis points for T-bonds? I has the effect of shortening the maturity of government liabilities. Why should a trillion dollars more or less going from 10 year debt to bank reserves have any impact at all on the global economy?

The best way to analyze these actions is from the micro-economic perspective. The fed is effectively sucking financial intermediation activity out of the unregulated financial sector into the less efficient regulated sector and by paying an above market interest rate on excess reserves the fed is subsidizing commercial banks to sit on the money.

I suspect that this policy is mildly contractionary from the macro point of view - really nobody knows. From the micro point of view, it can't be a good thing to subsidize regulated businesses to sit on their hands and not create value.

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